(Reuters) - Dysfunction in Washington is one of the biggest drags on the U.S. economy, undermining confidence and crimping growth, Treasury Secretary Jack Lew said on Tuesday.

"One of the most significant speed bumps for growth is coming straight from Washington, where some political leaders continue to generate one manufactured crisis after the next," Lew said in remarks prepared for delivery at the City Club of Cleveland.

Lew was in Cleveland to meet with local business leaders, tour a Vitamix factory, which makes blending equipment for food, and pitch President Barack Obama's economic policies.

He zeroed in on the local impact from $85 billion in across-the-board federal government spending cuts, known as sequestration, that went into effect at the beginning of March because Congress could not agree on an alternative.

He said the cuts meant 2,500 fewer Ohio children were enrolled in early childhood education programs known as Head Start, and less college aid for about 3,300 students in Ohio. The cuts also forced the cancellation of the Cleveland Air Show, as the aerospace and defense industries were forced to adjust.

"So it is high time we replace the sequester before it causes even more pain," Lew said.

The spending reductions were designed in 2011 to be so onerous that they would force the White House and Republicans in Congress to find a less drastic way to trim U.S. budget deficits. They included cuts to defense spending, normally dear to Republicans, and cuts to Democrat-supported programs like early childhood education.

But policymakers failed to reach an agreement and now must deal with the fallout, with cuts that total $1.2 trillion over 10 years unless they are replaced.

Lawmakers did quickly agree to spare the Federal Aviation Administration (FAA) after budget-tightening there started to cause flight delays and stirred public ire. Congress allowed the agency to shift money within its budget to halt furloughs of air-traffic controllers that began April 21.

"You saw in FAA, when something hit close to home, ... in three days (Congress) took action to deal with it," Lew said. He said lawmakers may feel more inspired to find an alternative to sequestration after going back to their districts during the August recess and seeing sequestration's effect on businesses and others in the economy.

"I remain optimistic that there will be a resolution to this," said Lew, who as Obama's budget director in 2011 participated in discussions that led to the sequester.

"But I will admit I underestimated the change in the political landscape, such as the defense cuts we're describing are not considered troubling to many Republicans now."

The U.S. economy grew at a moderate 2.5 percent rate in the first quarter, but appeared to brake sharply as the period drew to a close. Economists blamed higher payroll taxes that went into effect at the beginning of the year, and warned that the impact of the sequester had yet to be fully felt.

"Getting rid of the sequester is something we think is urgent," Lew said.

In contrast, Lew said he did not think discussions over the U.S. legal borrowing limit would cause the same disruptions to the economy.

Some Republicans in Congress have tried to use the so-called debt limit as a bargaining chip to force further spending cuts. The current suspension of the debt limit expires on May 19, although the Treasury can use emergency cash-management measures to push off the day of reckoning into August or the fall.

Once the United States reaches its debt limit, the government faces the prospect of defaulting on financial obligations, and potentially its debt, which could shake up markets and damage the economy.

"On the debt limit, I can't find anyone (in Congress) who wants to have a showdown," Lew said. "They understand it can't be a bargaining chip, because the mere negotiation over default hurts the economy."

(Reporting by Anna Yukhananov in Washington; Editing by Carol Bishopric)